CDS

Stress in the Spanish banking system is nothing new but with DS-K swooping in this week from the IMF, and the oh-so-trustworthy Stress-Tests due to be announced, anxiety was running high as Spain sovereign risk broke back above 250bps and BBVA and Santander struggled wider and flattened (CEE sovereigns also floundered today). Of course, far more importantly, World Cup favorites Spain lost their first round football match to the Swiss 1-0 (shame I hear you all cry).

According to DTCC, net notional outstanding in BP CDS as of June 11 was $1,676 million, based on 2,072 (great error-proofing there Reuters) contracts. This represents an increase of about 30% from the prior week, when net notional was $1,284 million and 1,718 contracts. Most notably, however, the increase is about 60% from $1,066 million and 1,399 contracts as of May 14. The 60% ramp up in CDS "hedging" is to be expected, now that PIMCO has gloriously entered the water. Of course, since nobody has used CDS to hedge positions since about 2002, this simply means that bets on a default in BP have surged. Observant readers will say this is the dumbest way to conclude this, when one can just look at the price of 5 Year CDS, which has exploded in the past month. These readers would be right.

For the first time in over 2 months, last week CDS traders ignored their ongoing derisking barrage in Great Britain CDS, and instead shifting their attention to the very heart of European darkness, the two countries that are in charge of it all - Germany and France. There was over 750 million worth of German CDS derisked, in 58 contracts, with France close behind at $728 million. Two other notable names rounding out the top five were Turkey and Spain. Quiet, little Finland was there for some reason. Other name filling out the list of top 10 were Brazil, Ukraine, Korea, Portugal and Japan: all names that have very valid reasons to be concerned about their future, and CDS traders agree. On the other end, rerisking was rampant in Mexico, Slovenia, Holland, Indonesia and Thailand. Most likely these are just hedge pairs as there is no reason why any of these names should be in play. Two names which we will focus on shortly, Romania and Bulgaria, were in no man's land. We expect they will slowly migrate toward the red part of the chart.

The BP Curve has really flipped (out). The 1 year point on the curve is now over 1,000 bps, a 400 bps move in one day. The point is also offerless (bidless in traditional cash jargon). Granted the DV01 so close to 0 is rather low, but this kind of ridiculous curve inversion is simply wreaking havoc on correlation desks. The 6 month point is now 0.5 pts upfront. Pretty soon BP will need to apply for the same ECB bailout that rescued all those banks who were risking a wipe out when Greek spreads were trading at comparable levels. The question now becomes: who sold the bulk of the BP protection? BofA's announcement yesterday that it is limiting counterparty risk exposure with BP to all contracts over 1 year could be a rather material clue as to the identity of at least one such entity.

The US government has revised its estimate for the daily oil spill for the third time, now decidedly higher than the last iteration which was at 25,000-40,000 barrels per day. The latest estimate puts the high end another 50% higher, at 60,000 barrels. If this is indeed the case, it means that the amount of oil already having leaked could be as high a 3 million barrels, or 12 times the amount spilled in the Exxon Valdez. Whether this means that the previous estimate of a total possible BP liability and other payments of $80 billion have to be adjusted higher once again, is still unknown. We hope the president's speech at 8pm will provide some more clarity on whether or not today's BP CDS Spread around 500 is justified.

Zero Hedge has long contended that risk models based on VaR "predictions" are flawed and only add to systemic instability due to the ever increasing correlations across all asset classes. We now read a first hand mea culpa from Morgan Stanley's Jim Caron, in which the head of the firm's rates strategy highlights precisely this problem: the complete collapse of predictive models when multiple sigma events like the May Flash Crash and the accelerating sovereign collapse of the past several months occurs: "April and May were difficult months for us and others, judging by fund data on market performance. We did not properly discount the risks associated with peripheral Europe. As a result, we had a larger risk exposure than we should have. We measure the return potential for our positions on a per-unit-of-risk basis, similar to a Sharpe Ratio. That unit of risk turned out to be much higher than we anticipated. This will force us, and many others, to right-size our risks." We wish we could agree with the last statement. Alas, each and every risk management group at comparable prop trading desks (to that of Morgan Stanley), will undoubtedly chalk off recent events to chance, and as these "will never recur", business we will promptly return back to normal, until we see another record crash in the Dow, only this time not 1,000 but multiples thereof.

“If you were to have faxed me this balance sheet and asked me to guess who it belonged to, I would have guessed, Citadel, Magnetar or even a proprietary trading desk at a bank.” So begins a story by Alexandra Harris of the Medill Journalism school at Northwestern, which, however, does not focus on some exotic product-specialized hedge fund, or some discount window (taxpayer capital) backed prop desk (hedge fund) at a TBTF bank, but instead at the 61% underfunded, $33.7 billion Illinois Teachers Retirement System (TRS), which just happened to lose $4.4 billion in 2009 (a year when, courtesy of America's conversion from capitalism to socialism, the market rose 60%), and 5% in2008. Yet underperformance can be explained. What can not, is that the TRS has now become a shadow AIG. As Harris notes "TRS is largely on the risky side of the contracts, selling and writing OTC derivatives, including credit default swaps, insurance-like contracts that guarantee payment in the event of a default, that were blamed in part for the 2008 collapse of Lehman Bros. and bailout of insurance giant American International Group Inc., or AIG." Demonstrating just how far the fund is willing to go in the "for broke" category, knowing full well that if it repeats AIG's implosion, the government will likely bail it out, is the disclosure that a stunning 81.5% of the fund's investments are considered risky - this means it is the fourth-riskiest investment portfolio for a pension fund in the U.S! All it will take is another Flash Crash-like event, or a liquidity crunch, and the 355,000 "full-time, part-time and substitute public school teachers and administrators working outside the city of Chicago" will likely end up with a big, fat donut in their retirement portfolios courtesy of some deranged lunatic, portfolio manager, situated externally at a bank like Goldman Sachs, who in taking a page straight out of Obama's bailout nation, has decided there is no such thing as risk. And to those naive enough to think the TRS is the only such fund which has now gone all-in on "no risk and infinite return", wait until such stories start emerging about every single massively underfunded pension and fully insolvent fund in the US.

The global equity markets are in meltup mode again. I want to take this opportunity to reiterate that I am still quite bearish on much of the situation in Europe. Let’s glance at the credit markets, major banks and the state of sovereign indebtedness in Spain.

Three days ago we brought attention to Soros' most recent outburst of negativity in a speech presented during a conference in Vienna, in which he said that "The collapse of the financial system as we know it is real, and the crisis is far from over. Indeed, we have just entered Act II of the drama." Below is the full text of Soros' speech. A teaser: "The first phase of the maneuver has been successfully accomplished – a collapse has been averted. In retrospect, the temporary breakdown of the financial system seems like a bad dream. There are people in the financial institutions that survived who would like nothing better than to forget it and carry on with business as usual. This was evident in their massive lobbying effort to protect their interests in the Financial Reform Act that just came out of Congress. But the collapse of the financial system as we know it is real and the crisis is far from over."

In a stunning development, and what may be the biggest loss for the Federal Reserve's lobbying power in history, the FT reports that "Banks are likely to lose a key lobbying battle in the US over whether they will be forced to spin off their lucrative swaps desks, according to people familiar with financial reform negotiations in Congress. Defeat, which would be a further blow to Wall Street, has been made more likely by Paul Volcker, the influential former Federal Reserve chairman, softening his opposition to the provision." If this indeed happens, the fallout for the US financial system will be dramatic, as numerous Wall Street spin offs would have to occur immediately in order to preserve CDS trading, an event that would will also adversely impact valuation multiples. The biggest problem with the Blanche Lincoln proposal, however, is that it still appears nobody really knows just what its full implications are. And adding more fuel to the fire, is the latest whisper from Volcker, whom many thought had relented on toning down his Volcker proposal to prohibit prop trading by banks: "Some senators want to modify the Volcker Rule, which also prevents banks from owning or sponsoring hedge funds in the name of risk reduction, to allow banks to “organise” a hedge fund and make an investment in a small amount of capital alongside a customer. But Mr Volcker thought that would be the thin end of the wedge, adding “from my point of view, I’d like it pure”. Could Wall Street be finally losing its tentacular grip over Washington? We, for one, will not believe it until we see it: after all Chris Dodd and Barney Frank's unfettered access to lifelong indulgences from the Clearing House Association lies in the balance.